Don’t Become Consumed By Valuation

KEVIN COLLERAN:The journey from great idea to great company can be very expensive — a journey that may require more resources than the average entrepreneur has at hand. The need for more money at the start often leads to this challenging question: Just how much is my idea worth?

This is tricky. Many entrepreneurs spend way too much time focused on the earliest valuation of their startup “company” (which may just be an idea) and end up distracting themselves from the most important thing they should be doing with their time: Building the business.

These earliest days are some of the most crucial of a company’s lifetime — and shouldn’t be consumed by valuation worries. Many entrepreneurs want to maximize the initial valuation of their business as a badge of honor purely for pride and bragging purposes. Rather than obsessing over valuation, I would urge entrepreneurs to focus on the following.

The Strength of the Investor. An entrepreneur should be more concerned with what potential investors bring to the table other than money. Clearly, it makes sense to shoot for the highest valuation possible in order to minimize dilution of the business, but in most instances, the smarter move would be to optimize for the quality of investor by exchanging more equity at a lower valuation for a rock star team of investors and advisers.

Find a team whose expertise will bring value that far outweighs the dilution. An entrepreneur’s decision to accept strategic money from a key investor — even at a more diluted rate — could be the deciding factor on how successful the company will become. It is always more valuable to surround yourself with investors who can help you grow the business, rather than an investors who are willing to pay a higher price but offer no other value beyond the money.

That said, it is important that the dollar amount from each strategic investor is large enough to be a ‘meaningful’ amount of money to the investor so as to encourage the commitment of time, resources, connections and other intangible value-adds.

Stay in Control. In the initial fundraising process, some investors will try to buy controlling ownership of a company away from the founding entrepreneur. This is especially true for first-time entrepreneurs who don’t have much experience or negotiating power.

It is rarely ideal to sell control of your company to an investor early on, even if the investor is willing to pay a much higher valuation than other investors. It is typically wiser to take money from investors who actually believe in you and your ability to run and grow your business rather than one who sees your need for capital as an opportunity to take advantage of the situation and take control of the business.

Properly Evaluate Your Needs. Many entrepreneurs make the mistake of misjudging the proper amount of money they need to raise in the initial stages. Some err on the side of caution and raise too much, resulting in giving up more ownership to investors than necessary, while other entrepreneurs raise too little and risk not being able to properly launch the company.

Neither scenario leads to a good outcome, but taking too little money and running out of cash is by far the worst option. Each business idea is unique and the amount of money and time that it will take to grow the company will differ based on the type of business and industry.

More important than valuation is the ability to properly judge financing needed to get the company to the next stage of development (and therefore the next round of funding). It is important to select investors who will be realistic and helpful in determining the proper cash needs for the business while also building a buffer in case things don’t go exactly as planned (as they never do).

Opt for Convertible Notes Instead of Valuation. Rather than focusing on valuation, find an investor who is willing to show support through a convertible note rather than a priced equity round. This is usually a simple process that allows an entrepreneur to obtain funds without going through the process of determining valuation. With a convertible note, the investor loans money to the company — and this money converts to equity at a future point in time when the company again raises money.

In exchange for being so generous in the early stages of the company, the investor is rewarded by getting a predetermined discount on the future valuation as well as a fixed maximum valuation so that the investor doesn’t suffer if the company grows very quickly before the next round of funding. This type of funding works best for businesses and industries that allow for fast and immediate growth.

Businesses that require a longer gestation period and are more complicated to grow may benefit from a small priced-equity round from supportive professional investors who will be long-term partners rather than the convertible note strategy.

In the long run, if the startup becomes successful, the difference between taking investment at a fair valuation — rather than a “great” valuation — will ultimately be meaningless since both the founding entrepreneur and the investors will share in the success.

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